The corporate tax conundrum: what's next for America?

Donald Trump’s eagerness to pick trade fights is threatening to undermine his own party’s plan to eliminate the corporate income tax. At the very least, it’s unquestionably made it more confusing.

Last week, White House press secretary Sean Spicer said Trump wanted to slap a 20% tax on goods imported from Mexico to pay for a new wall along the United States’ southern border. In the context of the escalating tensions between the two countries, the idea came off as just what it was: an undiplomatic, knee-jerk proposal to punish an important trading partner targeted by the US president.

But Spicer’s freelancing generated confusion about a serious proposal, developed over years, to restructure the US corporate tax system from one that taxes profits to one that taxes domestic consumption. It includes a 20% assessment on imports, but it is not targeted at Mexico, and its purpose is not to penalize trade.

The concept, called “border adjustment,” is a needed counterbalance to other business tax cuts in the plan, which has key backers like House speaker Paul Ryan, House Ways and Means Committee chair Kevin Brady, and Republican tax guru Grover Norquist. But its name and disagreements over how it might affect currency markets has led many to confuse it with the punitive tariffs called for by Trump, who seemed to dismiss this feature of the tax-overhaul plan just prior to taking office.

“Anytime I hear border adjustment, I don’t love it,” Trump told the Wall Street Journal in January, just days before his inauguration. “Because usually it means we’re going to get adjusted into a bad deal.”

The plan also has drawn criticism from some stalwart backers of tax cuts like Koch Industries, the influential petroleum conglomerate, and Wal-Mart, the mega-retailer, which rely on imports.

Yet border adjustment—and the consumption tax behind it—deserves consideration because it is what Trump might propose if he were interested in crafting policy not with the aim of offending trade partners, liberals, and the Republican establishment, but rather with the goal of bringing investment back to the US while still conceding the reality of a globalized economy. It also would fit with the world view of his trade advisor Peter Navarro, who is eager to tear down the global supply chains that undergird the success of US multinationals today. And, together with the other big changes under consideration in Congress, it might actually shift more investment toward the US without the negative consequences of punitive tariffs or the ad hoc cronyism of Trump’s twitter bullying.

The corporate tax conundrum

There is a consensus that the American way of taxing companies is broken, but the specific problem can be hard to agree upon.

Businesses and conservatives point to the top statutory rate of 35%, the highest among wealthy countries and the only that technically applies to worldwide income, as a reason for companies to steer investment elsewhere. Consumer advocates and liberals note that most businesses don’t actually pay this rate; the average effective corporate tax rate in the US from 2007 to 2011 was 22%. Indeed, even though corporate profits have reached record highs, the amount of revenue generated by the US corporate income tax has fallen steadily in recent years.

The disparity between the rate that is charged and the money that is collected is thanks to corporations exploiting tax breaks on everything from aging equipment to stock options for top executives. By far the largest effect is from the ability of corporations to defer tax payments on income earned abroad, which has led US companies to stash as much as $1.7 trillion in untaxed earnings overseas. Some of that money appears to be a result of companies shifting earnings overseas by moving their intellectual property (IP) abroad. And some firms whose income is entirely predicated on easily movable IP, like drug makers, have simply moved their headquarters to tax havens in order to escape US tax obligations entirely.

The complications of creating the financial structures to execute these schemes, coupled with the inevitable bad press when they get discovered, has had companies calling for change for years. At the same time, lawmakers and consumer advocates would like to see some of that cash come back home to create jobs and stop the parade of companies threatening to leave the US for tax reasons.

One frequently proposed approach is to pair the closure of tax preferences with a reduction in rates, resulting in a more economically neutral tax code. However, this framework largely crashed on the shoals of partisanship, specifically over the question of whether the new tax code should raise as much, more, or less money than the current version. Adding to the problem were fights over industry-specific tax breaks which turned any attempt at a rewrite into the lawmaking equivalent of a demolition derby.

By handing the Republican party full control over two branches of government, the 2016 election has clarified the matter. Without a Democrat in the White House or a Democratic majority in either house of Congress, there is no need to bargain over whether the corporate income tax needs to garner more revenue. Its elimination is now within reach of Republican lawmakers. Their plan, as expressed in their “Better Way” policy roadmap, is to get rid of the corporate income tax and its top rate of 35%, and replace it with a 20% destination-based cash flow tax with border adjustments.

A different way to tax businesses

What exactly does all that jargon mean? Let’s start in the middle, with cash flow tax. Currently, companies are taxed on their income, which leads them to conduct all kinds of accounting tricks to make sure their income is as far away from the tax authorities as possible, whether “deferred” in another country, or hidden in opaque transfers between subsidiaries.

Under the Republicans’ simple new framework, the government would simply tax the cash that flows through the firm, less cash expenses. That means an end to depreciation, the practice of deducting over multiple years the estimated cost of capital investments in things like computers or tractors. Companies wouldn’t need to attempt to value inventory over time, either. The complicated rules around both of these line items was a hassle for businesses and for the IRS, but talented tax professionals could, for example, exploit deductions for depreciation and debt to make the purchases of private jets essentially tax-free.

Under the House Republican plan, there would no longer be any special privilege for debt over equity, as in the current tax code. Though interest payments would be deductible like any expense, borrowed funds would be taxed as income. And companies could immediately write off capital expenses—whether a factory or, yes, a corporate jet—which would be a big gift to their bottom lines but also a major incentive for investment.

Economists consider this levy on corporate cash flow a consumption tax, because it falls on what consumers are ostensibly paying the company for—the value they add to their products, less the cost of the raw materials to purchase them. The Value-Added Tax, or VAT, is a popular example of this kind of consumption tax—effectively a national sales tax—enacted in many wealthy countries. Economists like to tax consumption because it’s not productive like savings or investment, and because there is so much of it. Indeed, VATs generate lots of revenue. Yet the VAT is also criticized because, as a sales tax, it is very regressive: It effects poor people more than the rich because the poor consume a greater share of their income.

The major difference between the VAT and what Republicans have in mind for the US is that corporations would be able to deduct their wage costs from their cash flow, which helps push back against the regressive nature of the tax by preventing the taxation of a worker’s wages and consumption in the same mechanism. It also could cause problems for the US’ standing with trading partners around the world, as we’ll see when we’re done understanding it.

The end of worldwide taxation

The next feature of the plan to think about is the destination-based aspect of it. Republicans propose to end the longstanding, uniquely American idea of taxing worldwide income. At the heart of the idea is that the US government shouldn’t be intervening in the global activities of its citizens, corporate or otherwise. Under their plan, if revenue comes from overseas, it wouldn’t be taxed in the US, at all. Likewise, overseas expenses wouldn’t be deductible.

If you consider for a minute about what kind of incentives this might create, one of the obvious ideas for an American firm would be to move production and intellectual property overseas, to a low-tax or low-labor cost country, while continuing to sell products in the US. Just as companies today try to shift income overseas because it is effectively untaxed there, they would similarly do so if their foreign income was untaxed by law.

To battle this incentive, we finally reach the border adjustment part of the proposal. The adjustment would, at its simplest, make it so that foreign purchases by companies would not be deductible, to balance the lack of taxes on exports—that is, the tax only targets domestic consumption. A company that attempted to game a destination-based system by importing goods would pay, under the Republican proposal, a 20% tax on them, while a competitor who obtained the same goods domestically would not. That major advantage to domestic producers has attracted the attention of politicians eager to exploit the prevailing winds of protectionism. What could look better than a tax on imports?

And here is where things start to get interesting and traditional tax policy alliances fray. Now instead of a generic battle between those who want to raise taxes and those who want to lower them, or even the usual intra-industry fights, the political conflict is between the importers and the exporters. To make things even more confusing, the tax plan’s biggest academic backers insist it won’t affect the US trade balance at all.

Will the currency catch up?

The initial flash point in all this starts with companies that import a lot of raw materials. Switching to this new system could cause, in effect, a 20% tax increase on these purchases. Companies that depend on imports, like the politically influential Koch Industries, which is one of North America’s largest importers of tar sands to be refined into petroleum products, have been paying attention.

“We worry that the border-adjusted tax provision proposed in the House Republican blueprint would adversely impact American consumers by forcing them to pay higher prices on products produced in and goods imported to the US that they use every single day,” Philip Ellender, the top government relations executive at Koch, said in a statement on Dec. 7.

The plan’s intellectual defenders have a different view. Two of the most prominent are Douglas Holtz-Eakin, a Republican economist who once led the Congressional Budget Office and is now president of the conservative American Action Forum, and economist Alan Auerbach of the University of California, Berkeley, who developed an earlier destination-based cash flow plan (pdf) at the Center for American Progress, the think tank that served as a Clinton administration-in-exile.

“The House blueprint, as a whole, moves the US from a tax code that advantages foreign production over domestic production, to a tax code that’s neutral,” Holtz-Eakin says.

But it wouldn’t create a permanent distortion, he and other proponents of the plan say, because the dollar to would quickly become more valuable relative to other currencies. This would be a natural result of companies moving to sell more products abroad due to the lack of tax preference, which means foreign buyers will need more dollars, while US companies purchasing fewer goods abroad would diminish their supply.

Speculators, Holtz-Eakin says, wouldn’t even wait for the law to take effect to bid up the price of the currency.

For example…

Before we get into the criticisms of the plan, let’s look at a few brief examples, generated by Holtz-Eakin and Auerbach, of how it would differ from the current code. Skip ahead if you’ve got it!

Consider this table showing the tax base—the amount of taxable money—from a company that purchases a third of its raw materials abroad but sells most of its goods in the US:

The big difference? The company is penalized for buying goods abroad with a smaller deduction and is taxed on a greater percentage of its income. But Holtz-Eakin and Auerbach argue that their idea “does not mean that the firm does worse after-tax under the new system, because its costs of imported goods will fall” with the appreciation of the dollar. If the dollar’s value increases commensurately with the tax, by 20%, the extra cost of the companies’ imports will be washed out in the company’s after-tax income by the additional profits. But if the dollar doesn’t behave as expected, the change in plans will mean a big new tax burden for American importers.

Of course, most of the biggest American companies are major importers and also major exporters. How will the tax code affect these companies? Take a company that sells an eighth of its product abroad and imports a third of its inputs:

Here, the tax base is the same under both systems, which gets at the neutrality between foreign and domestic activities that the the people behind the tax are talking about. One of its most interesting features is that it will make it much harder for big tech companies to push their intellectual property to offshore subsidiaries and pay tax-deductible royalties for the use of their own designs, because overstating foreign expenses and producing abroad will no longer lead to fewer tax deductions, not more.

This is the main point of the border adjustment: As co-director of the nonpartisan Tax Policy Center William Gale puts it, border adjustment “is not some wild, radical idea. It is a natural and logical part of the tax.” It keeps the tax focused on domestic consumption, while punishing efforts to manipulate cross-border transactions to gain a tax advantage.

Cash flow tax meets world

Not everyone likes this idea, for a lot of reasons. One key debate is whether the dollar would actually adjust the way border adjustment proponents think it would. In a world where countries have intervened in the capital markets to keep their currencies competitive, or have adopted domestic policies to protect trade surpluses, would foreign governments really allow the dollar to rise by such a large amount?

“The amount of currency trading having to do directly with international trade is between a tenth and a twentieth of the daily turnover in financial markets,” says Adam Posen, president of the Peterson Institute for International Economics and a former member of the Bank of England’s rate-setting committee. “The idea that this trade adjustment is going to have any major effect on the currency is crazy. And if the currency doesn’t appreciate, this is a total attack on the rest of the world.”

Should this tax policy be seen as protectionism—an attack on the rest of the world?

Its backers argue that border adjustment shouldn’t be interpreted like a tariff. The key difference is the exemption of taxes on export, which its backers are counting on to increase the value of the dollar, something that wouldn’t happen if a tariff was imposed on top of the existing . Such adjustments aren’t uncommon—European VATs, after all, are border adjusted, with Parisians paying sales tax on imported Wisconsin cheddar while US tourists can get a VAT refund when they leave France with their Camembert.

The problem here comes down to the rules of the World Trade Organization. It tolerates VAT adjustments because any deductions are applied equally in each market: In France, those who import from American cheese-makers pay a border adjustment while those who favor local French fromagers pay the VAT; outside of France, the patrons of cheese-makers and fromagers alike have no obligations to the French government. However, trade lawyers at the firm White & Case have looked at the Republican plan (pdf) and fear that some of its features, in particular the deduction for wages paid—which is not available to foreign firms—would violate the equal treatment rules the US has agreed to.

The lawyers argue that the policy could be written into law so that it fits within WTO rules, though removing the wage deduction would make the tax even more regressive. Or, the government could simply enact it and fight out any challenges at the global body, a tactic that may appeal to the pugnacious US president but might create unpleasant amounts of uncertainty for businesses, especially if other countries adopt border adjustments of their own.

The politics of taxing

The uncertainty whenever a clever idea like cash flow taxation with border adjustments meets the political reality in Washington is another reason that this plan has attracted opponents.

For one, it’s not clear yet how the plan will address financial businesses, and you can imagine lobbyists battling it out for loopholes—like special treatment for IP—that would unravel the benefits of the whole system.

Needless to say, Democrats are skeptical that such a radical change to the corporate tax is needed at a time when Republicans are already plotting huge tax cuts for the wealthiest Americans, who already benefit from some of the lowest personal tax rates in modern US history. And while they are unlikely to be able to win many compromises on reform, they will be able to turn up the political heat on Republicans if they make the tax system more regressive to benefit corporations.

“Let’s fix the tax we have by cutting rates, closing shelters, broadening the base and cracking down on tax havens,” former Obama administration economics adviser Larry Summers wrote in a recent op-ed. “That would be an important step to making our economy grow faster. It would also be fairer.”

Among his concerns are whether this tax will produce enough revenue to keep funding necessary government programs. By effectively cutting taxes on corporations, Republicans are hoping to see more revenue from economic growth. The latest estimate of the plan (pdf) suggest it will cut taxes for business by $900 billion over 10 years, which leaves a huge gap for growth to make up. More likely, the deficit will be covered through borrowing.

Similarly, Gale notes a missed opportunity to increase the amount of revenue under the more efficient system, not lower it. Because the corporate tax would no longer fall on profit, but on consumption, “there is no good reason to reduce the tax rate to 25/20 percent” in order to avoid bad incentives. Keeping the new cash flow tax too low could even lead tax avoiders to shift their individual income to businesses for lower rates. But Republicans, who insist that this must be a tax cut as well as a tax reform, aren’t likely to adopt high enough rates to win over liberals who appreciate the efficiency of consumption taxes.

Then there’s the awkward problem of indefinite refunds. Profitable companies that sell significant amounts of goods abroad while producing or buying them mostly in the US will consistently owe negative taxes and be due for refunds. Seeing these enormous firms awarded billion-dollar refunds from the public coffers every year would not be a winning position for any politician, even if it means these corporations are heavily investing and hiring in the US.

And while a failure of the dollar to adjust appropriately would undermine the plan, rapid appreciation of the dollar similarly would have negative political consequences around the world. For one, it would be an immediate wealth transfer—a boon for foreign companies and countries that have invested in US businesses or debt, like China, and an immediate loss for US foreign investments denominated in foreign currencies. On a broader scale, it would further upset the efforts of emerging markets to avoid currency problems and financial crises connected to their dollar holdings.

“Mysticism about the right value of the dollar is perennial and overvalued,” Holtz-Eakin says. “If you have dollar-denominated liabilities, they are more expensive to you. If the US were to undertake a big tax reform, and you’re the finance minister of a developing country, you certainly ought to have the brains to refinance.”

Unanswered questions

Right now these ideas lie dormant, awaiting the shakeout in the power structures of the new administration. Trump’s own economic brain trust is riven with conflicts between globally-minded financiers and economic nationalists that seek to protect the US economy.

While it’s hard to imagine Trump glomming onto any of these newfangled ideas, a destination-based cash flow tax might actually be a place for consensus between the two warring camps, combining an effort to ostensibly punish importers (even though proponents insist they won’t really be punished) while potentially cutting taxes for multinational companies.

In any case, the administration and Congress have promised a big tax-reform effort will be their top priority in 2017. It’s not clear that the White House is prepared to lead a major push for an alternate policy framework that does a better job of hitting Trump’s rhetorical notes, but Ryan and Brady have been laying the groundwork for their plan in the House for two years now, giving them an advantage.

“Because it’s the only live proposal out there, it’s getting an amazing amount of attention,” says Holtz-Eakin, warning that “it remains at this point a blueprint, not a bill. There is a a big distance to be traveled between what’s put out in a couple dozen pages and what will be marked up in the Ways and Means committee.”

One thing’s for sure: Republican dominance in Washington hasn’t brought an end to massive social experiments designed by reform-minded policymakers and conducted by federal law.